Wednesday, February 25, 2009

What Price For Market Liquidity?!?!?

What is the price for equity market liquidity in size? Anyone who has any doubts about what the precise number should or might beat present need only look at Phil Falcone's (Harbinger) sale of it's Fortescue (hey John H, read this!) stake to China's Hunan & Valin Iron & Steel group at 20% BELOW the so-called market, according to a Bloomberg news report.. And Fortescue is reasonably liquid, but apparently not liquid enough.

When I see such a tangible tell-tale of market-structure reality (typically the result of filings), I think of several topics that the thoughtful practitioners should ruminate upon:

(1) What is the meaning of this for the accrual and payment of performance fees upon "Last Market-to-Market" valuations? Seems Mr Falcone pocketed 20% of all the market impact on the way up.

(2) What does this say about the true value of certain activists true portfolio liquidation value, particularly those like Warren Lichtenstein's Steel Partners Japan Fund where the positions are equally large if not larger, but the turnover but a fraction of that in something like FMG.

(3) Audits should almost certainly carry serious caveat warnings about liquidity-adjusted valuations. I've raised this with senior audit partners at financial practices before and they've looked at me like I was the Devil incarnate. Yet their opinions are qualified regarding hundreds of minute details, yet it disregards perhaps the most important: mark-to-market is fallacy where positions are large and liquidity constrained.

(4) IF disposing of a 10% position requires a 20% discount, then imagine the intentional market-impact one can generate on the way in (both on long and short positions) which again is the cornerstone of incentive fees, and should highlight for allocators and investors the large potential for abuse, and near-certainty that before this is over, ALL peformance fees will be paid on a new industry standard of some kind of rolling three or five year window.

(5) Systemically, this is instructive on the essential need to avoid liquidation. Not avoid longer-term deleveraging, but wholesale point-in-time Mellon-like liquidation. Imagine for a moment that "failing banks" (currently insolvent, or near-insolvent) are liquidated, and the extreme market impacts of their sales upon asset prices will of course force others into insolvency merely exacerbating the situation. Th LTCM managed unwind is a reasonable model here. Warehouse the risk, unwind it orderly in due time. For forcing systemic liquidation does not equate to market efficiency. Price discovery in illiquid markets is likely to result in overshoot, and exacerbate systemic difficulties. This doesn't mean that said asset prices warehoused are over, or undervalued, but that selling position to make position is merely systemically sub-optimal with real negative cascade impacts upon employment and output.


Charles Butler said...

Try promising Tiffany that you'll pay up when the clinic's confirmed that she hasn't left you with a dose.

constantnormal said...

Why are you not in the government -- say as either Federal Reserve chairwoman or Secretary of the Treasury?

Yet here you are, blogging away and making perfect sense in near-obscurity.

IF said...

Did you see this (via Sudden Debt)
"Banco Santander SA, Spain’s biggest bank, said it may sell its holding in Cepsa for as much as 3 billion euros ($3.9 billion). The bank is in talks to sell its 31.6 percent stake in Cepsa for between 30 and 35 euros a share, it said today in a statement. The midpoint of the range is less than half of Cepsa’s closing price of 66.75 euros on Feb. 23."

Mencius Moldbug said...

Girlfriend - as usual, you are so right. When I need a deep, intuitive, and above all feminine understanding of deflationary economics, I come to Cassandra's.

I would, however, venture one minor correction - entirely a linguistic matter. Rather than liquidity preference, I would say maturity preference.

Ie: your maturity preference is the price you are willing to pay in present dollars for future dollars. This is of course a yield curve with a value for every time T, terminating at the origin and becoming absurd for times beyond a human lifespan.

(Use of the word liquidity for this concept, though standard, is euphemistic, misleading and profoundly incorrect. An illiquid asset is one in which it is difficult and/or expensive to arrange up a transaction - such as a house. Toxic assets are not illiquid in this sense of the word. They are illiquid in the sense that their present holders have motivations, chiefly the result of our dysregulatory system, not to accept the market price. Hence the need for euphemism.)

A loan market, when functioning normally, aggregates all the individual yield curves on the demand side, and return curves on the supply side, into a single lending market with a market yield curve. This yield curve is not static, but it is stable - it changes only as the individual yield and return curves change.

Eg: what should the interest rate on a 1000-year loan be? That depends on the number of people who are willing to borrow 1000-year money, and the number who are willing to lend it.

In other words, what we are seeing in these bids is no more and no more less than something like a free-market interest rate. And a high one, as it should be.

Free-market interest rates are high because the people, before the crash, who lent money for 30 years didn't really mean to lend it for 30 years. A vast supply of short loans was transformed into a supply of long loans. Then the transformer broke, and this supply vanished. The debt, however, remained.

So yields should increase. A lot. And thus, prices should fall. A lot.

So as in the '80, there is no conceivable recovery which does not involve high interest rates. Fortunately for the '80s, they actually got a dose of this medicine. I don't think we will.

True - it is very difficult to separate interest rate from default risk in these vulture-food assets. Both are very high. If you can devise a way to distinguish the two, a Nobel Prize and billions of dollars await you. Of course, the same can be said for a perpetual-motion machine.

In particular, calculating default risk from Treasury rates at the equivalent maturity simply does not work for these assets, because the two have become separate markets with different demand schedules.

The pool of lenders who want Treasuries is now quite a bit different from the pool of lenders who want to buy securitized real-estate loans. Namely: the former still gets its demand to lend from people who don't really want to lend. Whereas the vulture investors are actually aware that their money will be locked up for some time. Ie, they want to lend.

And thus we reiterate Cassandra's lesson: it is an delusion to suggest that there is some true "market price" for these assets. The only market interest rate is one obtained by shutting down all classical banking entirely, and having the only lenders be "vulture lenders," ie, real lenders.

We are not going to go there, and we probably shouldn't. Instead, USG should own up to the fact that its dysregulation (CRA on the left, NRSROs with formulaic rating on the right) was responsible for these bad loans, consolidate the nominally private entities that made them on its own balance sheet, and convert loans backed by toxic assets into obligations of USG itself.

What we are seeing at present is a set of dishonest attempts to try to do this, while pretending not to do it, and (more importantly) not actually shutting down the system which caused the problem. Whether this works or fails, the outcome will be disastrous. But disastrous in different ways, unfortunately, which makes it hard to bet on.

comrade darkness said...

mark-to-market is fallacy where positions are large and liquidity constrained.

I'm going to hazard a lay person's comment here. Seems like scenario-based valuations would be of use. It would also have the added benefit of forcing management to acknowledge that there are multiple realities with regard to their true viability.

Blissex said...

«Instead, USG should own up to the fact that its dysregulation (CRA on the left, NRSROs with formulaic rating on the right) was responsible for these bad loans, »

This is awesomely intellectually dishonest that it is too funny.

First, the CRA has had absolutely zero impact on this mess -- the numbers are just too small to matter.

And to blame just the government dysregulation for this mess is a gigantic travesty. Executives taking paper profits and turning them into cash bonuses for themselves? Government dysregulation. Mortgages made on 100% LTV and no documentation to generate huge commission income for rich brokers? Government dysregulation. MAKE MONEY FAST scammers getting loans to flip homes in an ever rising market? Government dysregulation. The Japanese central bank and the Fed hading over free money to the businessmen sponsoring the parties in power? Government dysregulation.

And so on -- but it is a joke -- the government surely is rather responsible for a lot, but it was a government sponsored and directed by Wall Street and other business interests.

Sure, there was government lack of regulation. And this was intentional, and was designed to generate large paper profits for wealthy speculators. Let's look at some extracts from a 1997 debate on derivatives regulation:

«Futures exchanges, furthermore, have the highest possible self-interest in maintaining the integrity of their markets and preserving the public's trust in the institution and the industry.»

«Alan Greenspan noted in his Coral Gables, Fla., speech, government must "enunciate clearly" the public policy objectives for the regulation of derivatives. These so-called "professionals" use OTC derivatives as an integral part of managing their firms' financial business. They are subject only to the remedies imposed by contract law, which have apparently been sufficient since the number and size of derivatives-related defaults are statistically insignificant. Accordingly, it is not clear exactly what public policy purpose government regulation is serving.»

«Despite the unfounded doomsday predictions of some, self-regulation does not mean no regulation. Nobody has more at stake in the integrity of our markets than we do. Our professional markets would continue to offer customers many well-known safeguards already found in exchange markets, including open and competitive trading, transparent pricing, daily mark-to-market of positions, and unsurpassed financial integrity through clearing systems that eliminate counterparty risk.
Each of these safeguards was invented by exchanges, not the federal government, because the integrity of our markets is paramount to our success. Yet with all these safeguards in exchange markets, there are some who favor more regulation of exchanges. Nobody has yet explained to our satisfaction why the safer market should have more federal regulation.

«Therefore, to the extent that excessive regulatory burdens impact the exchanges' ability to offer cost-effective, innovative products, ISDA members are less able to use those products efficiently in connection with managing the risks of their own businesses, and less able to offer competitively priced, privately negotiated transactions for customers to manage their business risks.
While there are significant differences between exchange-traded products and privately negotiated products, we do support efforts to formulate a statutory exemption that would allow exchanges to offer products in a less-regulated environment. This would permit exchanges more flexibility to provide financial products that in turn can create opportunities for privately negotiated transactions.

«At the same time, the professional market exchange would not be subject to audit trail, books and records, and other regulatory requirements that are essential in uncovering, and thereby deterring, fraud and manipulation and ensuring sound operations. Problems of the magnitude seen in recent trading scandals involving professional traders such as Barings and Sumitomo show too clearly the limitations of relying only on exchange self-oversight. Such events also demonstrate that institutional participants in exchange markets can pose potential systemic problems. Moreover, an unregulated professional exchange could profoundly affect clearinghouse integrity in the event that a firm cannot honor its trades. Problems at the professional market or clearinghouse could easily spill over to the broader financial markets.»

«We know that there is a strong relationship between trading in derivatives and related case markets. We know that there is, at best, incomplete information on the extent or nature of trading in these markets. We also know that a market in which regulators have no legal ability to require trading reports, to impose "circuit breakers," position limits, trading halts or margin requirements if they should prove necessary, to obtain the information required to monitor the markets, or to mandate fair competition among participants, is a market that could present great potential dangers for the nation's regulated securities markets. Actions that would preclude regulators from addressing systemic risk should not be taken unless it can be concluded that such action would be safe and in the public interest, and would have no adverse effect on the proper functioning of and competitive balance in securities.»

«DS: So is it conceivable that state gaming laws would become applicable to trading on the CBOT or Merc?
BB: I think that's an issue that probably would be explored.»